The private placements controversy
Securities issuance in India is now dominated by private placements. Every now and then, we hear about the "impending scam" in the private placements market. What is going on? Is there something which regulators should do?
The rationale for regulation At the heart of all regulation in finance, we find two core elements of rationale:
- Contract enforcement. The State can help by enforcing contracts, and by enforcing against fraud. This covers errors in disclosure, and violations of contractual terms.
- Investor protection. Small investors often do not have the incentive to invest resources into information gathering and information processing about the financial products that they face. A larger flow of savings into the financial markets can come about if regulators protect small investors.
The role of the State in contract enforcement is undisputably valuable. The role of the State in protecting small investors, in contrast, has a more limited role. If two economic agents wish to engage in a contract, and they are "large enough" to take care of themselves, then it makes sense for the State to allow them to proceed on the transaction without the regulatory requirements that flow from investor protection.
In other words, the country should have a "normal" track of financial processes where regulations are derived from the principles of contract enforcement and investor protection. However, it should be possible for economic agents to "opt out" of regulations based on investor protection, to do transactions where the State only plays the role of contract enforcement.
One prominent example of such contracting is found in fund management. Normally, when a household hires a fund manager, it uses a mutual fund. It makes sense for SEBI to intensively regulate mutual funds, with an eye to protecting the interests of the household. This umbrella of protection is crucial in generating confidence on the part of the household in a fund manager.
SEBI's regulations impose costs on mutual funds, directly through the costs of compliance, and indirectly through the opportunity cost of techniques of fund management that are prohibited by SEBI. Suppose a fund manager announces that he will only accept investors who put up more than Rs.1 million each. We can argue that by the time this threshold is reached, we are no longer dealing with small investors who need protection. Hence, SEBI should allow this escape clause, where a fund manager faces SEBI regulations insofar as contract enforcement is concerned, but is otherwise unregulated. Such a fund management entity is called a "hedge fund", and is a missing element in India's financial markets today.
By this same argument, firms should be able to opt out of regulatory requirements for public issues if each investor buys securities worth more than Rs.1 million. The argument is that any such investor has adequate incentives to invest in information gathering and information processing to take care of his own interest; so the role of the regulator should only be to enforce against fraud. This is the idea behind the "private placement route".
In a subtle and interesting way, hedge funds put a check on regulators of mutual funds, and private placements put a check on regulators of public issues. If the burden of regulation is too onerous compared to the benefits of regulation, then economic agents will tend to "opt out" of regulation, and choose the unregulated path. This is valuable for the economy, which is not forced to pay the costs of inefficient regulation. To the extent that this exerts pressure on regulators to reduce the costs of compliance, this is also a good effect. By this reasoning, we need hedge funds in India today, in order to keep mutual fund regulators honest.
With this backdrop, let us turn to the raging arguments about private placements:
- There is concern that private placements are non-transparent, where there is no information in the public domain about the transactions that are taking place.
- There are concerns that private placements are taking place based on poorly drafted contracts, where buyers of securities would not be able to effectively enforce on fraudulent issuers of bonds.
- There are concerns that a lot of privately placed bonds could default, yielding NPAs. There is a certain lack of confidence in the credit ratings which many bonds earn.
Gaps in information. The basic principle of consenting adults opting out of regulation is a good one. However, there are important externalities from information disclosure. Economic efficiency in the economy as a whole is enhanced when more information is public. Hence, we can make a case in favour of greater public information even when a placement is private.
Concerns about defaults. If every investment in a private placement is larger than Rs.1 million, then we would like to believe that buyers have adequate incentives to do a good job of decision making.
The major concern which should give us pause is about agency conflicts in most finance companies in India, such as banks, mutual funds, etc. If an individual was putting Rs.1 million of his own money into a single security, we can be certain this individual has sound incentives. But if this individual works for a finance company, then are the incentives sound?
In particular, consider an environment where the individual making the decision is underpaid, has job security, has supervisors who are not serious about performance measurement and wage/promotion incentives, and regulators have a poor track record of investigation and enforcement. In this environment, can we count on this individual making sound decisions when engaging in a loan or a private placement?
The way forward. There are two elements of a public policy response to this situation:
- The short term answer is to favour transparency. Sunlight is the best disinfectant, and a key element of dealing with agency conflicts in Indian finance is to move towards transparent products and markets. Securities are more transparent than loans. Anonymous trading on the electronic exchange is more transparent than bilateral contracting.
From this perspective, we should strengthen public information dissemination associated with private placements. Consenting adults should continue to be free to transact without going through public issues, but we should constrain them to report more information about their activities to the public.
- The long term answer is to address the agency conflicts in Indian finance. This involves private ownership, private sector HR policies, and eliminating entry barriers into banking for both new domestic banks and for foreign banks.
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